Friday, May 21, 2010

Sovereign Debt is a Ponzi Scheme .....written by Greg Gann

The outstanding national debt of the United States as of May 2010 is just under $ 13 Trillion. The estimated population of the United States is approximately 300 million. This means that each citizen’s share of the current national debt is about $42,000. Since September 2007, the national debt has increased at an average rate of $4.10 Billion per day. [1]

Author, Martin Bell provides some great visual images to clarify the magnitude of the problem. He finds that the U.S. dollar is 0.10922mm thick. A stack of just $1 trillion would extend one quarter of the way to the moon. The dollar covers an area of 0.01034 square meters. One trillion dollars would cover the combined area of Washington, D.C., Rhode Island, and Delaware. So, to give a realistic image of our existing debt, multiply these images by a factor of 13.

In studying eight centuries of sovereign debt problems, Professors and co-authors Carmen Reinhart and Kenneth Rogoff cite in their book, This Time Is Different, that when the debt of a nation reaches 100% of its GDP, there is a reduction in potential GDP growth of approximately 1%. Today, the existing debt of Greece is 120% of its GDP. Italy’s is approaching 115%. Portugal’s debt is approximately 85% of its GDP. The United States is rapidly approaching a debt level close to 100% of our nation’s GDP. [2]

John Hussman, Ph.D., one of our clients’ investment managers, describes what is happening today in world markets as a Ponzi scheme. He describes that the price of an asset should reflect the future stream of income that the asset will generate, what is known as discounted cash flow. Ponzi schemes are created when assets are assigned greater values than their expected future cash flows can justify. Asset prices continue to rise when the purchaser believes that he will find a subsequent purchaser who will pay an ever higher price for the asset than he did regardless whether cash flows justify the higher price or not. When prices are no longer pegged to value, and value is no longer determined through reasonable expectations of those future cash flow payments, a bubble is created. This is exactly what we experienced in the late 1990’s dot com bubble. Stock prices were divorced from cash flows, and buyers were confident that there would continue to be future purchasers in line to continue to jack up prices. The trend continues until it ends. Everyone makes money in the Ponzi game until there is no one left in line willing to participate. The same thing happened with real estate.

As long as there is an assumption that the assets which support the debt will continue to rise, then no one believes that debt is the problem. Countries like Greece don’t have the luxury of devaluing their currencies. As the perception of sovereign defaults magnifies, investors will demand higher interest payments to justify the risk. An increase in interest rates on trillions of euros or dollars for that matter translates into a spiraling of the crisis. There is a problem when you have to borrow more just to cover the additional debt service costs.

The euro was an experiment. Unifying currencies of different nations with diverse cultures and values and work ethics and liabilities is a recipe for challenge and conflicts. On top of all these issues, Japan, countries in the Eurozone, and the United States are facing aging populations and growing unfunded liabilities. The Greek bailout will cost the U.S. dearly in terms of our contributions to the IMF. The United States and countries around the globe have simultaneously circulated a lot of money to combat systemic problems which have been brewing for years. The U.S. Treasury virtually nationalized our mortgage market. While debt can serve as a temporary band-aid, eventually growth must lead the way. Eventually there reaches a point of no return. You cannot resolve mountains of debt by issuing more debt. Eventually your credit worthiness gets called into question, and when that happens there become less parties interested in taking the risk, and the Ponzi game ends. And the problem is that there is no easy way out of the mess. Plans for greater fiscal responsibility, now termed austerity plans, mean that growth may slow. If there is fear that a currency may be devalued, well then who wants to risk being paid back in that currency.

When states like Pennsylvania and California are bankrupt and major countries around the globe are as well, it is hard for me to believe that we are in a long-term bull market. The problem now, from a trader’s vantage point, is that we are getting big spikes up in the market on certain days which are followed by craters. If we bet against the market, we are hurt during those up days. And, if we bet in favor of growth, we are hurt on those down days. To navigate in these waters, we are deploying additional technical indicators to assess market risk. We are also monitoring holdings with even greater scrutiny, and quite frankly, we are doing a lot of trading on both the buy and sell side. We are also allocating to investments that have cushions to help protect from the downside.

We are one world. And we are truly a small world. What happens in Europe has a direct, even if delayed, impact on the United States. As the euro weakens, the dollar strengthens. A stronger dollar is positive to some extent, but a stronger dollar makes exports collected by American companies more expensive because it costs more for the buyers of those exports to pay for the goods in dollars. In my humble opinion, any investor who feels complacent today because his investments have rebounded to a large extent from losses incurred during 2008, is either naïve or not getting the research to which we are exposed. This is a period where you should work to protect and preserve gains, and to actively monitor your holdings and the market and trade according to what the market dictates rather than what a pre-established, computer-generated asset allocation model outlines.

I am privileged to have earned the confidence of clients to proceed accordingly as a fiduciary on their behalf.

The opinions voiced in this material are for general information and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, you should consult a financial advisor prior to investing.



[2] Hedgeye Risk Management